The math
The ESPP discount is a sure thing. The stock is not.
An employee stock purchase plan lets you buy your employer's stock at a discount. The discount is a sure gain. People lose it with the decision that comes after the purchase.
How the plan works
Section 423 of the tax code lets a plan sell you your employer's stock at up to 15% below its market value. You pay through payroll deductions during an offering period. At the end of the period, the plan buys the shares for you.
Some plans have a lookback. With a 15% discount and a lookback, the price is 85% of the lower of two prices. One is the price at the start of the offering. The other is the price on the purchase date. Our example uses an offering of 6 months, with one purchase at the end.
The law also sets a limit. You can buy up to $25,000 of stock a year, valued at the start of each offering.
The discount is a return
At 85 cents for each dollar of stock, each dollar that you put in is worth about $1.18 on the purchase date. That is a gain of 17.6% before tax. The deductions come from each paycheck, so on average a dollar waits only about 3 months for that gain.
| Stock price over the offering | Gain on $10,000, with a lookback | Return | Gain after tax at 24% | Return with no lookback |
|---|---|---|---|---|
| -30% | $1,765 | 17.6% | $1,341 | 17.6% |
| -10% | $1,765 | 17.6% | $1,341 | 17.6% |
| 0% | $1,765 | 17.6% | $1,341 | 17.6% |
| +10% | $2,941 | 29.4% | $2,235 | 17.6% |
| +30% | $5,294 | 52.9% | $4,024 | 17.6% |
With a lookback, 17.6% is the floor for a sale on the purchase date. If the stock falls, the plan buys at 85% of the lower price. Your shares are then still worth 17.6% more than you paid. If the stock rises, the plan buys at 85% of the price at the start, and you get more.
The tax on the discount
You sell before the two required periods end. The sale is then a disqualifying disposition. The discount on the purchase date is wage income. At an assumed 24% rate, the $1,765 gain at a flat price leaves $1,341.
You hold for 2 years from the start of the offering and 1 year from the purchase. The sale is then a qualifying disposition. The wage income is the smaller of two amounts: your actual gain, or the 15% discount on the price at the start. The rest of the gain is a long-term capital gain, which has a lower rate.
At a flat price, the two choices pay the same tax, $424. The better treatment helps only when the stock rises. Suppose that the stock is up 30% on the purchase date and stays there. Then a qualifying disposition saves $318 of tax.
What it costs to keep the shares
To get the better treatment, you must hold one stock for 18 more months. We compare two choices on 50,000 simulated paths, with the same market in both.
In the first choice, you sell at the purchase, pay the tax and put the rest in an index fund. In the second, you hold the shares until month 24. The employer stock has the same expected return as the market, 7% a year. It also has risk that belongs to the company alone, so its volatility is 29.7%, against 16% for the market.
| After tax at month 24, from $10,000 | Sell and buy the index | Hold the stock |
|---|---|---|
| Average | $13,430 | $13,632 |
| Bad case, 1 path in 10 | $10,304 | $8,484 |
| Median | $13,052 | $12,675 |
| Good case, 1 path in 10 | $17,032 | $19,898 |
| Ends below the $10,000 that you put in | 7% of paths | 22% of paths |
The choice to keep the shares adds $202 on average. That comes from the lower tax rate, and from the return on tax that you pay later. For that amount, you accept a much wider range. In 54% of the paths, the shares end behind the index. In 29%, they end behind by more than $2,000.
The comparison does not penalize the shares. We gave the employer stock the market's expected return. If you think that your company will beat the market, you make a separate bet, and the plan does not pay you for it.
Your job is already a position
Your pay already depends on your employer. If the company has a bad year, the stock and your job can suffer at the same time. Our essay on employer stock shows that cost in detail.
What to do
Join the plan if you can afford the deductions. A gain of 17.6% before tax, fixed on the purchase date, is rare.
Sell the shares when the plan buys them. You keep the discount, and you do not add to a position in your employer.
Use the money for your next priority. Our essay on the order of operations gives a sequence.
Read your plan document. Find the offering dates, the lookback, and any rule about when you can sell.
What this leaves out
The model has no state tax and no brokerage fees. It ignores the interest that your deductions could earn during the offering. It uses one offering of six months, with one purchase. Some plans use longer offerings with several purchase dates. A loss on either choice reduces tax at the long-term rate in the model. The model also assumes that you sell on the purchase date, at the price on that date.
Sources
- 26 U.S. Code section 423, Employee stock purchase plans, for the 15% limit on the discount, the $25,000 limit, the two required periods and the wage income on a qualifying disposition.
- 26 CFR section 1.421-2, for the wage income on a disqualifying disposition.
- IRS Topic No. 427, Stock options, for the addition of that income to the basis of the shares.